L&T Emerging Business Fund forced into small caps by SEBI’s new rules?

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Following the Securities and Exchange Board of India (SEBI)’s reclassification rules for mutual funds, L&T Emerging Business Fund will be required to raise its minimum small cap allocation from 50% to 65% to comply with SEBI rules. The definition of small caps is also being changed towards even smaller companies. This is likely to heighten the risk that investors in the fund will face.

L&T Emerging Business Fund was launched on 12th May 2014. It has delivered a 30% CAGR since inception, over almost four years. A 30% CAGR over four years will almost triple your money. The scorching returns made the fund immensely popular. It got such inflows that it had to close the gates in December 2017. It stopped accepting new inflows, switch-ins, SIPs and STPs over Rs 2 lakh and the restriction continues to this day. The fund has an AUM (assets under management) of Rs 4,404 crore.

In October 2017, SEBI announced its new fund classification system. The system defined a ‘small cap’ fund as a fund investing at least 65% of its assets in companies smaller than the top 250 by market capitalisation. L&T Mutual Fund decided to place the Emerging Business Fund into this slot.

L&T Emerging Business Fund is allowed by its current mandate to invest 50-100% of its assets in small-cap companies, compared to 65-100% set by SEBI rules. The current mandate defines small caps as those companies below the top 200, while the new mandate defines them as those below the top 250.

A look at the fund’s current portfolio validates the apprehension, that the fund will be pushed sharply towards small caps by SEBI rules and the change of its mandate. According to Value Research, 49.4% of the fund’s assets are invested in mid-caps rather than small caps. Another 1.73% are in large companies. Morningstar puts the mid-cap proportion at 48.6% and it puts another 1.26% of the fund in large-cap companies.

The tilt towards mid caps is so strong that Morningstar has assigned the S&P BSE Midcap Index as its benchmark to the fund rather than the S&P BSE Small Cap Index, which the fund declares as its benchmark. You may argue that Value Research and Morningstar do not define small caps as those below the top 250 companies by market cap. However, our analysis shows that their methodologies arrive at roughly the same dividing line. In other words, L&T Emerging Business Fund may be required to sharply cut its mid-cap allocation from nearly 50% to 35%.

Why does this matter?

Small caps are more volatile than mid-caps and are less liquid. A burst of redemptions can force large sales by a small cap fund can lead to huge losses, simply because there isn’t enough liquidity to accommodate the sales. This is precisely why many small-cap funds in India clambered out of small caps and into mid-caps as they grew large. L&T Emerging Fund went as far into its mid-caps as its mandate permitted and now it will have to reverse course.

What options do you have?

If you are an existing investor, you can redeem your investment from the fund without paying any exit load until 11th May 2018. However, you may have to pay short-term capital gains tax of 15% if you have held the fund for less than one year. If you have held the fund for more than one year, you will be liable for a 10% long-term capital gains tax on gains made after 31st January 2018. Long-Term Capital Gains up to Rs 1 lakh will be exempt from taxation. Alternatively, you can stay put and accept the higher risk.